World Industrial Production: The Long Recovery in the Developed World

I'm currently writing an article about post(?)-crisis globalisation and I'm focused at the moment on the idea of decoupling. Supporters of the decoupling thesis argue that Asia or emerging economies are now considerably less reliant on the West for their growth.

Having read Eichengreen and O'Rourke's article tracking the global financial crisis (or Great Recession) against the Great Depression I was interested to see what had happen to industrial production. The authors did a couple of updates to the original 2009 article, but finished updating in 2010 when it was clear that the world economy was not continuing to track the GD, largely because of considerable state intervention that helped to bolster economic growth and avoid beggar-thy-neighbour economic policies.

Looking for recent stats on industrial production I came across this research from Yardeni Research.

The figures are quite staggering and show how badly developed economies have performed in comparison to developing (emerging) economies.

In the first graph, which covers the entire world minus construction, the impact of the financial crisis is clear as is the excellent performance in the lead up to the crisis.

But it is when we disaggregate IP that we get a clearer picture of the impact of the crisis.

Compared to Europe the United States has done reasonably well. Even Germany the so-called success story of Europe has not recovered to its pre-crisis peak.





While the developing world - especially Asia - has clearly outperformed Western economies, the
danger is that the impact of the crisis has simply been delayed in emerging economies and that they now face a period of retrenchment as investment (especially state-directed) slows and debt has to be repaid. Developing countries have benefitted from global supply chains involving China and the spur to their own investment from Chinese investment.

The idea that stimulus - especially in China - would enable emerging economies to ride out the crisis is ultimately dependent on renewed global growth, especially in the developed world. The US and European economies are still the major source of final demand for many of the goods made in the developing world often through regional production structures and global supply chains.

Increasing Dependence on Asia

The IMF has just released its new Regional Economic Outlook: Asia and Pacific: Managing the Next Phase of Growth, April <http://www.imf.org/external/pubs/ft/reo/2011/APD/eng/areo0411.htm>. There is an interesting little section on "Spillovers from Emerging Asia to Australia and New Zealand" on p.6. 

The IMF notes that Australia is now much more dependent on "Emerging Asia's" (that's a category that includes China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam) demand than it ever has been before. While this has been beneficial for Australia in recent years as Asia recovered quickly for the GFC and global recession, it also means that a slowdown in Asia will be felt brutally in Australia. As the IMF points out Australia’s exports to Asia have increased from 40 per cent of the total to 60 per cent between 2000 and 2010. Using a structural vector autoregressive (VAR) approach, the IMF concludes that over the past 10 years economic shocks from Asia are now considerably more important to the Australian business cycle than shocks from the United States.  

For the sample period 1991–2010, a 1 percent shock to U.S. GDP is found to move Australian growth by about 0.4 percent. In contrast, GDP shocks from emerging Asia have an almost negligible impact on Australian growth. This result changes dramatically when limiting the sample period to 2000–10, for which a 1 percent shock to emerging Asia’s growth is found to shift Australian growth by ⅓ percent, whereas the impact of U.S. GDP shocks on Australia is no longer statistically significant.

Commodity prices dominate the transmission of shocks from emerging Asia to Australia. The three transmission channels identified in the model—trade, commodity prices, and financial variables (including interest rates and equity prices)—account for most of the estimated spillovers to Australia. In particular, commodity prices alone explain half of the spillovers from emerging Asia to Australia.

This means that Australia that there has been a switch in business cycle dependence - Australia has "decoupled" from US growth over the past 10 years and "coupled up" with Asia over the same period. 

Note however that the jury is still out about whether Asia has decoupled from the United States over the longer-term. (Although it certainly appears that the decouplers are currently on top). The rest of Asia of course is increasingly tied into China's fortunes, making debates about China's inflation, housing bubble and debt increasingly important. 

The IMF, like most Australian economic bureaucrats is bullish about Australia's economic future: 

The long-term trend of continued strong growth in emerging Asia bodes well for Australia. The IMF’s Global Economy Model (GEM) can be used to assess emerging Asia’s impact on Australian long-term growth prospects. The model captures two main channels through which emerging Asia’s growth can affect Australia: trade integration and terms-of-trade gains. The simulation suggests that, should emerging Asia continue to grow notably faster than the world average, the impact on Australia will be even larger than in the past. This larger impact reflects both the increase in emerging Asia’s economic size and Australia’s growing integration with emerging Asia. Over the next 10 years, the model suggests that a 50 percent increase in emerging Asia’s real GDP, driven by tradable sector productivity growth, would raise Australian GDP by about 20 percent (figure). However, should emerging Asia’s economic growth become more balanced, with productivity growth in both tradable and nontradable sectors contributing equally, the growth dividend is roughly cut in half, owing to more modest improvements in the terms of trade of Australia.

A few other graphs also make interesting viewing about Australia's position in Asia. The first shows that Australia has relatively high real (after inflation) interest rates compared to a selection of other Asian economies and the second shows the significant real appreciation of the Australian dollar

Predictions of Doom 2

Nearly all posts about the potential for doom in the Australian economy revolve around housing, either directly or indirectly. The best writers on potential housing trauma are Leith van Onselen who writes a brilliant blog backed by reasoned argument and a myriad of data (some of which I had referred to in my book so I know it's right!!). Other excellent doomsters are David Llewellyn-Smith and Delusional Economics. All believe that Australian house prices are over-valued and that household debt is a real problem for Australia. If you are inclined towards bearish sentiments about housing then these writers will seriously make you worry. While the housing market is obviously very important I want to focus on some bigger picture variables that will undoubtedly affect not just the housing market but the wider Australian economy.

Now the point is no one really knows what will happen to the Australian economy this year but we do know what factors will matter. Former RBA governor Ian Macfarlane once argued that if you only had one variable to understand the Australian economy then the variable you would choose would be the international economy. But the problem with this simplistic (but reasonably accurate) scenario is that the variable itself has changed. In other words the international economy as a variable affecting Australia has changed. The part of the international economy that matters most for Australia is now China and Asian generally. It would have seemed absurd 10 years ago to have a US economy in severe crisis and the Australian economy to be experiencing a boom, but the Chinese economy has changed the global economy enormously.

But as I've written continually the real question for Australia is how the sub-variable China is affected by the wider variable of the international economy, which is still dominated by the Western economies, despite the rise of the developing world over the last 20 years or so. Can China continue to grow in 2011 if the US and Europe remain affected by financial woes and hamstrung by low growth. This is the so-called de-coupling debate.

I've written previously about decoupling. Indeed I wrote in January last year that:

2010 will provide some further evidence for the long-running debate over decoupling. The financial crisis bolstered the anti-decoupling case as world financial markets were universally shaken by events in the United States. Since this time, however, the decouplers' argument has looked more sound as some began to talk of a North Atlantic financial crisis rather than a GFC. Certainly, Asia did well in 2009 compared to what many thought lay ahead at the end of 2008. Govt stimulus in China has helped enormously, but even in China this can't go on forever.

No doubt we shall get further evidence about whether China and the rest of Asia is ultimately as export dependent as economists like Stephen Roach contend and whether the issue of final Western demand really does continue to matter.  

Well it looks like the 2010 evidence is that decoupling had some legs over the course of last year, but at the risk of taking liberties on extensions (and to mix the metaphor) I think that the jury is still out. 2011 will provide further evidence because recent US tax cuts notwithstanding, the impact of fiscal stimuli throughout the world will be further unwound and the need to pay off debts will continue. Debt really is the thing to watch in 2010, not just public debt as the media wants to focus on, but household debt as well, not to mention the seemingly forgotten problem of foreign debt.

As David Barbosa writes in the NYT (via Michael Pettis):

For nearly two years, China’s turbocharged economy has raced ahead with the aid of a huge government stimulus program and aggressive lending by state-run banks. But a growing number of economists now worry that China — the world’s fastest growing economy and a pillar of strength during the global financial crisis — could be stalled next year by soaring inflation, mounting government debt and asset bubbles.

Now this is a common theme of China bears but Pettis is even more bearish:

I have almost no doubt that during 2011 all the growth expectations are going to be revised sharply downward. By the end of next year, I suspect that the consensus will be that for the rest of the decade we should expect growth rates in the 6-7% range for China.

Do I believe these lower numbers? Not really. About a year and a half ago I wrote in a Financial Times article that, assuming consumption growth could be maintained at 8-9% a year, Chinese GDP growth would average 5-7% annually over the rest of the decade.

My prediction caused a lot of strong disagreement and accusations of being overly pessimistic, but the truth is I think I was being optimistic. If GDP growth slows so substantially, it seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range. But I do think the consensus next year will migrate down to the 6-7% range, even though next year’s growth should remain high – probably in the 9% range.

Barbosa argues that Chinese problems will have significant ramifications for the rest of the world economy (a reversal of the traditional Western-led 'coupling' or 'globalisation' argument).

A sharp slowdown in China, which is growing at an annual rate of about 10 percent, would be a serious blow to the global economy since China’s voracious demand for natural resources is helping to prop up growth in Asia and South America, even as the United States and the European Union struggle.

And because China is a major holder of United States Treasury debt and a major destination for American investment in recent years, any slowdown would also hurt American companies.

Pettis does not agree with Barbosa that a slowdown in China will be bad for the world or for the US:

I am not sure why Chinese holdings of USG bonds suggest that a Chinese slowdown will hurt US companies, but I have already explained why I do not think a sharp slowdown in Chinese growth is necessarily bad for the world. It will be very bad for commodity exporters – or at least non-food commodity exporters, since I think the demand for food from China will continue strong – but the overall effect on the rest of the world depends on the evolution of China’s trade balance. A contraction in the surplus creates net demand for the world, and so might even be marginally positive.

This marginally positive outcome won’t be evenly distributed, of course. Non-food commodity exporters will be badly hurt, while commodity importers and manufacturers will benefit.

I don’t even think such a rapid slowdown in Chinese growth will be bad for China. Again it depends on how it takes place. If there is a serious attempt at rebalancing the economy by raising wages, interest rates and the currency, China can manage a much slower GDP growth rate while still maintaining a fairly high growth rate in household income and consumption. I discussed this in more detail in an entry last month.

Non-food commodity exporters obviously means Australia (although we do export food as well).

Pettis then provides some notes on what is worth watching in 2011. Wisely he does not call them predictions.

First, although I do not believe inflation [in China] is going to be as big a problem as many think (I believe the Chinese financial system has a built-in inflation-stabilization mechanism – see my November 18 entry), if I am wrong and inflation continues to rise, this will create a real problem for monetary policy.

Second, debt levels are worryingly high and are starting to act as a serious constraint on the rebalancing process. My friend Victor Shih at Northwestern University has done great work in trying to figure out the government balance sheet, and he worries, correctly, in my opinion, that it is becoming increasingly difficult for the PBoC to raise interest rates without creating a great deal of financial distress in government-related entities. Even the PBoC balance sheet is a real problem. How can they raise RMB interest rates without running a huge negative carry?

Third, the trade constraints are going to get worse, not better. Ashoka Mody and Franziska Ohnsorge have a very interesting piece on Vox that suggests that we shouldn’t count too heavily on consumption growth in the developed world to boost global demand. That means we are going to spend the next few years fighting over anemic demand growth, and we will be apportioning that demand via trade disputes.

Fourth, although GDP growth rates next year will be very high to see off the current leadership, I am pretty sure that by the end of the year there will be much more concern about the rebalancing process and what that will mean for growth rates. In order to get those high growth rates, I don’t think we need to take the 2011 lending quota too seriously. Whatever it is, it will be breached.

Another China-focused economist is Andy Xie who argues:

By the middle of 2011, most analysts may declare that the world has finally put the financial crisis behind.

The reality is quite different. The global economy is kept afloat by massive monetary and fiscal stimulus around the world. The main problem in the global economy – high costs and declining competitiveness in the developed world, and inflation plus asset bubbles in the developing world continue unabated. Either inflation in the developing world or unsustainable sovereign debt in the developed world will spark the next crisis.

...

The most likely candidates to trigger the next global crisis are the U.S.'s sovereign debt or China's inflation. When one goes down first, the other can prolong its economic cycle. China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.'s trade deficit can drop dramatically, maybe by 50 percent, due to lower import prices. It would boost the dollar's value and bring down the U.S.'s treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

This coming year is China's opportunity.

The best way for China to deal with inflation, according to Xie, is to address its property bubble.

China's inflation problem stems from the country's rapid monetary growth in the past decade. That is due to the need to finance a vast property sector, which is, in turn, to generate fiscal revenues for local governments to finance their vast expenditure programs. Unless something is done to limit local government expenditure, China's inflation problem is likely to get out of control.

The government now recognizes inflation as the country's main challenge. It has raised interest rates once, deposit reserve ratios several times, and announced its intention to introduce price controls. The barrage of unconventional measures is due to the belief that China's economy is different from others and the conventional measure of raising interest rates may not be effective or necessary. The reluctance to change the price of money and the willingness to change the price of goods and services has not worked well so far.

...

The ineffectiveness of the recent measures casts doubts on the government's sincerity in fighting inflation. The constant and marginal policy announcements could be interpreted that the inflation fighting is now largely a propaganda job. Such perceptions could spark popular panic, which would cause the household sector to hoard goods like rice and cooking oil. When the masses flee from holding money, a full blown crisis will unfold.

So at the beginning of 2011, we are in a similar position to the start of 2010. Debates about China will produce much heat in Australia, the real question is whether they'll produce any light. For what it's worth I think that economic liberal commentators have too much faith in the Chinese Communist leadership to manage the Chinese economy without booms and busts. While China will probably continue to grow rapidly over the medium term, the belief that it can continue to grow uninterrupted by poor policy decisions and the reality of economic cycles is pure fantasy.

I also have no doubt that by this time next year we'll have a clearer position on the debates about globalisation and decoupling and about the ability of Australia to profit from a long-term mining boom.

Predictions of Doom 1

This one from Eisuke Sakakibara via William Pesek.  Sakakibara argues that “the world is set for a long-term structural slump reminiscent of the 1870s” meaning that he thinks that there will be a return to recession in 2011 lasting until 2018.

Pesek argues:

recent data in the US and Japan and financial turbulence in Europe suggest a fresh global recession is a distinct possibility in 2011. If that happens, what levers are realistically available to revive demand? Interest rates are already at, or close to, zero. That leaves increased government spending as the only real way to stabilize things.

The trouble is, there’s little support for opening the fiscal floodgates in a meaningful way.

One reason is that there’s already loads of public debt out there.

What worries lots of doomsters is that the world might be heading for 1937 again where Roosevelt and many others felt the recession was over and relaxed only for the US economy to go backwards the following year.

As with my previous post a real question for coming years is how long China can continue to grow without expanding demand for its exports from the US and Europe.

If Sakakibara is right, the global economy is in deep trouble. He envisions a broad slowdown that might drag on for seven to eight years. China can live a couple of years without US and European growth, but eight?

To head it off, governments need to up spending. And, for the most part, they aren’t. Yet the US can, and should, borrow more. To do that, it just needs to become a bit more Japanese, says Richard Duncan, author of the “The Corruption of Capitalism.”

There’s a single reason why Japan’s 10-year bond yields are below 1.3 per cent and Asia’s No. 2 economy isn’t being downgraded. Since about 95 per cent of Japan’s debt is held domestically, there’s no risk of capital flight. Japan borrows from its companies and people, an arrangement that’s roughly the mirror image of the US.

The problem for the US on the other hand is the extent of financial vulnerability due to foreign holdings of its bonds.

That so many Treasuries are held in China and elsewhere makes the US highly vulnerable. Duncan, chief economist at Blackhorse Asset Management in Singapore, says the US needs another FDR-like New Deal to restore growth and competitiveness. Funding one means greater borrowing and the way to do it is by tapping private-sector cash, Japan-style.

Such suggestions are likely to fall with a mighty thud on Capitol Hill, which is moving in the opposite direction. Lawmakers calling for Ben Bernanke’s head forget why the Fed chairman is taking US monetary policy into uncharted territory. It’s because Congress failed to pump enough money into the economy in the first place.

Japan is a cautionary tale. On the surface, the 4.5 per cent annualized increase in third-quarter gross domestic product looked promising. The detail, however, showed that deflation is worsening no matter how many yen the Bank of Japan churns into the economy. This is anything but a typical recession, and world leaders are too distracted to see it.

In the US, the focus is on China’s currency. While a stronger yuan would be in the best interests of the global economy, it’s not the answer to all the US problems. Japan is even more obsessed with exchange rates. And Europe is linearly focused on convincing investors that the euro zone won’t unravel.

In our time of currency fixation, perhaps a guy called Mr. Yen is the ideal messenger. Too bad his message is one of economic gloom as far as the eye can see. Perhaps even to 2018.

For a more local prediction of possible doom see one of my favourite bloggers Leith van Onselen, who highlights China's empty cities and what they might mean for Chinese demand for Australian resources when the Chinese have to EVENTUALLY stop building stuff no one is buying.

Stephen Roach on China

Stephen Roach's comments on Asia and China are always worth noting. See "It's not yet Asia's world: Stephen Roach"
Once again I agree with this piece's argument that the jury is still out on whether all is hunky dory. Because commentators often like to imagine that tendencies are already established realities, China's rise is already seen as total victory over the US and the West. There is still a long way to go as I argue in Chapter 3 of The Vulnerable Country.

Roach argues that recovery will be weak:

"Headwinds linger in the form of write-downs by financial institutions, the breadth of the global recession, and chronic weakness in the demand side of the world — the American consumer — and the persisting imbalances in the supply side of the world — Asia, and in particular in China." ... "there’s a lot of complacency here, presuming that the post-crisis world is Asia’s for the asking"

He is not, however, overly pessimistic (neither am I) he just thinks that it's a big assumption to think that China can be the engine of global growth. It's just not there yet.

The real danger is a prolonged period of stagnation (or worse) in the US and a failure of China to adjust its growth model towards higher wages and greater domestic consumption.

All of this, of course, will affect Australia greatly.

A Renewed Boom for 2010?

It now appears that Australia has fully moved on from any notion of crisis and 2010 is now being seen as the year of "the return of the boom".

But there are, as usual for those of us negative vibe merchants (I prefer the notion of "vulnerability watcher"), some things to worry about:

What happens to China's economy will continue to be important. Chinese demand for Australian commodities fell away in late 2009 as David Uren points out in The Australian. "Commodity shipments to China fall as speculative stock build-up eases". But this is not necessarily an indicator of a collapsing market. There has been a lot of speculation and there are ongoing issues of stockpiling and stategic asset buying. (Certainly the Chinese appear to have messed up in the arena of iron ore purchases)

The job for policy-makers is to think about vulnerabilities and not get too carried away with the view that a renewal of a commodities boom is inevitable.

The US economy continues to be mired in recessionville and further stimulus is being contemplated.

2010 will provide some further evidence for the long-running debate over decoupling. The financial crisis bolstered the anti-decoupling case as world financial markets were universally shaken by events in the United States. Since this time, however, the decouplers' argument has looked more sound as some began to talk of a North Atlantic financial crisis rather than a GFC. Certainly, Asia did well in 2009 compared to what many thought lay ahead at the end of 2008. Govt stimulus in China has helped enormously, but even in China this can't go on forever.
No doubt we shall get further evidence about whether China and the rest of Asia is ultimately as export dependent as economists like Stephen Roach contend and whether the issue of final Western demand really does continue to matter.

China and America: Global Imbalances and Decoupling Yet Again

An interesting point made by Tyler Cowen (Dangers of an Overheated China) about the US-China economic relationship.

PRESIDENT OBAMA’S recent trip to China reflects a symbiotic relationship at the heart of the global economy: China uses American spending power to enlarge its private sector, while America uses Chinese lending power to expand its public sector. Yet this arrangement may unravel in a dangerous way, and if it does, the most likely culprit will be Chinese economic overcapacity.

This captures in a neat way the substance of the current relationships and the dangers as well. The US economy is still in a bad way. If you're in any doubt about this have a read of Gretchen Morgenson (Get Ready for Half a Recovery). Once again the issue comes back to the global imbalances (Chinese current account surpluses versus US deficits) and decoupling (or not).

Cowen might be alarmist in his concerns about overcapacity but it seems that there is substantial evidence to back the overcapacity case up. Chinese banks have kept on lending and Chinese companies have kept on producing but who's buying this extended production?

China has been building factories and production capacity in virtually every sector of its economy, but it’s not clear that the latest round of investments will be profitable anytime soon. Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. In Shanghai, the central business district appears to have high vacancy rates, yet building continues.

Chinese planners now talk of the need to restrict investment in sectors that are overflowing with unsold products. The global market is no longer strong, and domestic demand was never enough in the first place.

Regional officials have an incentive to prop up local enterprises and production statistics, even if that means supporting projects or accounting practices that are not sustainable. For an individual business, the standard way to get more capital resources is to put forward a plan for growth. Because few sectors are mature, and growth has been so widespread, everyone can promise to be profitable in the future.

 

Can China keep on growing without final demand, particularly from the US? There's a lot at stake for Australia as well. China has kept on buying those resources throughout the global recession but eventually it has to sell things to keep buying our resources.

Chinese production is now helping to fund US deficits, which in turn is keeping the US economy afloat. The hope is that the US fiscal stimulus kick starts the US economy, which keeps Chinese factories rolling over, which allows Australian miners to keep selling minerals to China.

It could all work out, but then again it might not.

Cowen outlines perhaps the worst contingency:

China has had a 30-year run of stellar economic growth. But it’s only human nature for such expansion to breed too much optimism, overextending an entire economy. Americans have found this out the hard way in their own financial crisis.

History has shown that no major economy has grown into maturity without bubbles, crises and possibly even civil strife or civil wars along the way. Is China exempt from this broader pattern?

The notions of excess capacity and malinvestment were common in business-cycle theory of the 19th and early 20th centuries, when growing Western economies had frequent crashes of this kind. Numerous writers, from the Rev. Thomas Malthus to the Austrian economist Friedrich A. von Hayek, warned about the overextension of unprofitable capital deployments and the pain from the inevitable crashes. These writers may well end up being a guide for understanding China today.

What will the consequences be for the United States if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.

In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments and recoup their losses. American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And even if the Chinese are selling more at lower prices, they may be taking in less money over all, so they may have less to lend to the United States government.

In any case, China may end up using more of its reserve funds to address domestic problems or placate domestic interest groups. The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.